December 28, 2005

1 in 4 chance of a recession within 12 months

Many standard economics textbooks report that an inverted curve is a leading indicator of an imminent economic slowdown. The traditional reasoning goes something like this: when short-term rates are relatively high, demand for loans slackens, weakening the economy. And bond traders, collectively seeing so many signs of an impending economic slowdown, have already driven down longer-term rates in anticipation of an eventual loosening of short-term credit.

The statistical support for this indicator looks impressive. Arturo Estrella, an economist at the Federal Reserve Bank of New York, contends that an inverted yield curve "has predicted essentially every U.S. recession since 1950 with only one 'false' signal."

At first blush, there is no evidence that the indicator is losing its touch. It worked like a charm, for example, in forecasting the economy's most recent recession. According to the National Bureau of Economic Research, the widely recognized arbiter of when recessions begin and end, that recession began in March 2001. The yield curve went negative the previous summer.

Mr. Estrella and Frederic S. Mishkin, a professor of banking and financial institutions at Columbia University, have built an econometric model that relates various levels of the yield curve with the probability of a recession within 12 months. With the rate on 10-year Treasury notes now just about half a percentage point higher than that for three-month Treasury bills, for example, the researchers' model calculates a 10 to 15 percent probability of a recession within the next year. That probability would grow to about 25 percent if the difference in rates disappeared, and would grow even further if the curve inverted, meaning that the short-term rate was higher than the longer-term one.

The difference between the 2-year and 10-year notes is about zero, so we have about a 1 in 4 chance of a recession within 12 months. I'll begin hoarding money (M1) and/or gasoline on January 1.